Think Half Of A Cycle Ahead

Summary

Financial markets are trendy and noisy in the short run, sensible in the long run, and perverse in the intermediate term.

Short-run movements are news-driven, and driven by people trying to catch up with the latest data. Many people imitate the behavior of others, and over the intermediate term, some stock prices get out of whack.

Some subset of industries, factors, and/or companies gets out of alignment, and are mispriced. In the long run, those pricing errors get corrected, but it takes years to get there.

Financial markets are trendy and noisy in the short run, sensible in the long run, and perverse in the intermediate term.

What do I mean?

Something like this: short-run movements are news-driven, and driven by people trying to catch up with the latest data. Many people imitate the behavior of others, and over the intermediate term, some stock prices get out of whack. Some subset of industries, factors, and/or companies gets out of alignment, and are mispriced. In the long run, those pricing errors get corrected, but it takes years to get there.

Here's an example. to make this tangible and understandable. As a factor, value has been bad for eight years or so, and as evidence, I quote Rob Arnott, from his article entitled, 'How Can "Smart Beta" Go Horribly Wrong?'

The value effect was first identified in the late 1970s, notably by Basu (1977), in the aftermath of the Nifty Fifty bubble, a period when value stocks were becoming increasingly expensive, priced at an ever-skinnier discount relative to growth stocks. More recently, for the past eight years, value investing has been a disaster with the Russell 1000 Value Index underperforming the S&P 500 by 1.6% a year, and the Fama-French value factor in large-cap stocks returning −4.8% annually over the same period. But, the value effect is far from dead! In fact, it's in its cheapest decile in history.

And then later he says:

How many practitioners who rely on the value factor take the time to gauge whether the factor is expensive or cheap relative to historical norms? If they took the time to do so today, they would find value is currently cheaper than at any time other than the height of the Nifty Fifty (1972-73), the tech bubble (1998-2003), and the global financial crisis (2008-09).

a) The shorts already have been killed. You don't hear about them anymore. There is general embarrassment over investments in short-only funds.

b) Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.

Point (b) is what I want to highlight… not that we have had many value managers forced into retirement recently, but value funds of all kinds have been losing clients. It's like being fired fractionally, a sliver at a time, but it adds up to a lot.

Combine that with Arnott's insight that the valuations of value stocks are at exceptionally low levels - this gives me some hope that we are in the seventh inning or later in this market cycle regarding value investing.

Going Back a Step

Value isn't the only cheap area presently - European stocks and emerging market stocks look cheap as well. When areas of the market with bad relative performance have a lot of people giving up on them to pursue recently successful strategies, that helps to put in the bottom on the underperformers, and the top on the outperformers.

You can't tell exactly when the process will end, but those jumping from one strategy to another, chasing performance, will just add a new set of losses to the old ones. The trick is to try to anticipate when the cycle will turn for a given market strategy, factor or industry. No one can do it perfectly, but it makes sense to act when relative valuations are in your favor.

Minimally, those that stick with a valid strategy through thick and thin can benefit from the strategy over the long term… and that takes some courage, because there are times when your strategy will be out of favor. That's what I do with value investing.

Maximally, you would sell a strategy that you were invested in that was topping out in relative terms to buy a strategy that has been trashed for a while, and might be ready to outperform. That's even more difficult than sticking with one strategy through thick and thin. Everyone wants to buy a past winner, and nobody wants to buy a past loser. But that is what would offer large returns if the timing could be right. Another way of phrasing it is to always look half a cycle ahead, to where a strategy will be when the excesses correct, or as is more likely, over-correct, and take the appropriate action now.

Doing that is beyond me. I'm just grateful that the period of relative underperformance of value may be nearing its end.